What Could Possibly Go Wrong?

By David S. Waddell

The most commonly cited indicator of complacency, the VIX or volatility index, recently hit a low of 10.73, a level not seen since early 2007.

Now a low VIX does not in any way signal an imminent crisis, but it does indicate a very complacent consensus susceptible to even slightly unpleasant surprises. Sadly, when the markets cannot find a reason to sell, Murphy ’s Law always provides one.

Iraq

The Middle East is a powder keg. Over the years, U.S.-U.N. intervention has doused lit fuses only to be surprised when others catch. Trying to introduce Western ideals to Middle Eastern minds during a religious civil war has been ambitious. Sadly, the most natural path for the region is combustion, which flares frequently and explodes periodically.

Oil prices connect the conflicts in the Middle East with the markets in Manhattan. As conflicts escalate, crude prices escalate reflexively. Fluctuating energy costs impact economic growth and corporate earnings. Oil prices spiked $5 in reaction to the most recent turmoil, knocking the S&P 500 down slightly over 1 percent. Let’s examine the various the sectors within the S&P 500 over this period to identify the vulnerable. Consumer names lost nearly 2 percent as rising oil costs reduce retail demand for everything not oil. Utilities, materials and industrial sold off 1.8 percent, 1.6 percent and 1.4 percent respectively as highly energy intensive sectors. Financials are indirectly related, falling 1 percent as rising oil prices limit economic growth overall and the demand for banking services. Healthcare and technology fell .6 percent and .5 percent in economic sympathy with the broader market.

The Lesson

Overall, the investment impact of rising tensions in the Middle East hasn’t been severe. However, the introduction of an unknown “unknown” did present smelling salts to the snoozing consensus. Reflecting upon last week’s events, an important investment lesson reintroduced itself:

1) Buy when there is no good reason to.

2) Sell when there is no good reason to.

At W&A, we reduced our “consensus” allocation earlier in the year and reinvested in more “contrarian” locations. We did not do this out of any specific fear, but out of respect for fear. The growth in economics, earnings and central bank support since 2009 has become a featherbed of comfort for investors. Performance trends in sectors and themes had been steady and prolonged, leading to overinvestment. We saw biotech and high-tech suffer the consequence of crowds earlier in the year as prices collapsed. With wide divergences between “trend” valuations and “countertrend” valuations, it made sense to us to rebalance.

Bottom Line

The events in Iraq may escalate and complicate any and all investments, but for now the damage has been contained and instructional. The conflict has rightly interrupted the market’s tranquility. Areas of the market that have steadily outperformed must now be re-justified. Areas of the market that have lagged significantly should now be re-examined. By nature, a change in trend favors the countertrend. Incidentally, which “countertrend” sector has performed worst over the trailing three years? Natural resources (i.e., energy plus materials).

David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.